Managerial Economics
Lecture Twelve:
Standard theories of
international competition
Theory & Reality…
An undisputed truth?
Belief in superiority of free trade near universal amongst
economists
Basic proposition put by Samuelson & Nordhaus:
– ―Simply put,trade promotes specialization,and
specialization increases productivity.‖ (297)
Argument essentially unchanged since Ricardo in 1817:
– Trade lets countries specialise in producing goods in
which they have a comparative advantage:
Not absolute productivity relative to other country,but
Comparative productivity with respect to own industries
Free Trade and Specialisation
Ricardo’s ―Comparative Advantage‖
– Took case Mercantilists argued would mean
rival (Portugal) would ―defeat‖ England in open
trade
Portugal assumed better than England at
producing everything
Argued that England would still benefit from
free trade
– The Model:
Free Trade and Specialisation
Two countries producing 2 commodities
Assume Portugal
– Absolutely more efficient at producing both
wine and cloth
– Relatively more efficient at producing wine
than cloth
More of both wine and cloth produced if
– England specialises in cloth
– Portugal specialises in wine
Countries trade surpluses and increase
consumption of both goods in both countries
Comparative Advantage
Portugal (per 1000 men)
– 90 men to produce x units of cloth
– 80 men to produce y units of wine
– can produce
11.1 units of cloth; or
12.5 units of wine; or
any ―straight line‖ combination of the two
England (per 1000 men)
– 100 men to produce x units of cloth
– 120 men to produce y units of wine
– can produce 10 units cloth,8.5 units of wine,or
any linear combination:
Comparative Advantage
So with no trade:
– Portugal Max,11.1 cloth,or 12.5 wine
– England Max 10 cloth,or 8 1/3 wine
Trade
– Portugal 12.5 wine,England 10 cloth
– Exchange surpluses,total output greater
Putting Ricardo’s arguments in a diagram…
Comparative Advantage
W
ine
Cloth
Wine output
without trade
Cloth output without trade
Cloth output with trade
Wine output
with trade
Trade,England produces only Cloth,
Portugal only Wine; output higher
Comparative Advantage
―Under a system of perfectly free commerce,each
country naturally devotes its capital and labour to such
employments as are most beneficial to each,This pursuit
of individual advantage is admirably connected with the
universal good of the whole,By stimulating industry,by
regarding ingenuity,and by using most efficaciously the
peculiar powers bestowed by nature,it distributes labour
most effectively and most economically.‖ (Ricardo 1817)
Clever logical argument aided repeal of Corn Laws
Identical to modern economic belief
– (Ricardo’s model is economics’ ―one big trick‖)
Show increase in output by reallocating static resources
But behind Ricardo’s rhetoric,a Realpolitik…
Ricardo’s Realpolitik
,It has been my endeavour to shew throughout this work,
that the rate of profits can never be increased but by a
fall in wages,and that there can be no permanent fall of
wages but in consequence of a fall of the necessaries on
which wages are expended,If,therefore,by the extension
of foreign trade,or by improvements in machinery,the
food and necessaries of the labourer can be brought to
market at a reduced price,profits will rise.‖ (Ricardo 1817)
Ricardo’s real interest not efficiency,but
– shift income from landlords to capitalists (workers
irrelevant to Ricardo)
– Real objective to increase rate of investment
Modern Comparative Advantage
If price of wheat falls
– Rents fall
– Money wages fall (cheaper wheat) while real wages
remain constant
– Increased profits
– Greater accumulation
– Objective,promote growth by redistributing income
Neoclassical Heckschler-Ohlin-Samuelson trade model
– Exclusively static
– Therefore ignores income distribution & hence growth
issue
– Basic theory by Heckscher,Ohlin,Samuelson,Vanek
– Best shown using ―Edgeworth Box‖ analysis:
Modern Comparative Advantage
PCs (―capital intensive‖)
Sh
oe
s (
―la
bo
r in
te
ns
ive
‖)
Price ratio
,Production
possibility
curve‖
,Social
indifference
curves‖
production
Consumption
outside PPC
consumption
PCs (―capital intensive‖)
Sh
oe
s (
―la
bo
r in
te
ns
ive
‖)
Modern Comparative Advantage
Fervently believed in by most economists:
– ―The principle of comparative advantage holds that
each country will benefit if it specializes in the
production and export of those goods that it can
produce at relatively low cost,Conversely,each
country will benefit if it imports those goods which it
produces at relatively high cost,This simple principle
provides the unshakable basis for international trade.‖
(Samuelson 300)
– ―Notwithstanding its limitations,the theory of
comparative advantage is one of the deepest truths in
all of economics,Nations that disregard comparative
advantage pay a heavy price in terms of their living
standards and economic growth.‖ (308)
Modern Comparative Advantage
But model makes some extreme assumptions
– Full employment of all factors of production
Otherwise countries would not be on ―Production
Possibility Frontier‖
– Costless mobility of factors of production between
sectors
Labour and capital can be moved from computer
production to shoe production without loss of
productivity
– Immobility of factors between countries
Otherwise gains in one country would accrue to factor
owners in another country
– Identical technology used in production everywhere
Initially,even Samuelson admitted qualms about them:
Modern Comparative Advantage
―The Ohlin analysis explains much; but there is much that it fails to
explain; and if adhered to inflexibly,there is much that it can
obscure,Its two central tenets are open to grave doubt:
Is it reasonable and useful to set up the hypothesis that production
functions are the same the world over? Is it possible to find
reasonably homogeneous and commensurable factors of production in
diverse parts of the world,so that relative proportions can be
defined and compared?
Certainly no strong affirmative answers to these two questions can
be given—as Ohlin himself has pointed out in a number of places,The
laws of nature may be the same ―everywhere,‖ but the laws of nature
and the economically relevant production function relating maximum
output obtainable from specified concrete inputs are two quite
different things…‖ (Samuelson 1948 ―International Trade And The
Equalisation Of Factor Prices‖,Economic Journal Vol,63)
So maybe the ―unshakable basis‖ isn’t all that sound…
Let’s consider the data…
Modern Comparative Advantage
Model makes several empirical predictions:
– Direction of trade determined by relative factor
abundance
Country with relative abundance of capital should export
capital intensive goods
Country with relative abundance of labour should export
labour intensive goods
– Incomes and trade
Trade should cause ―factor price equalization‖,wages
and return on capital should tend to equality throughout
world under freer trade
– Trade surpluses should be counterproductive
Trade surplus should only lead to inflation since
economies in full employment
– Free Trade best route for development
Exploits country’s comparative advantage
Direction of Trade,―Leontief’s Paradox‖
Wassily Leontief (father of input-output analysis)
analysed US trade flows in 1953
– Found that US exports were labour intensive &
imports capital intensive
Exports capital component $14K per man-year
Imports capital component $18K per man-year
Reverse of Heckscher-Ohlin-Samuelson prediction!
– Composite ―export‖ & ―import‖ commodities defined
– Composite ―labour‖ and ―capital‖ factors
– Later generalisations (more disaggregated
commodities & factors) generally reached same result:
Pattern of trade opposite to predictions of HOS theory
– Some recent results find theory valid but only if
another result of theory dropped,factor price
equalization‖…
Direction of Trade,―Leontief’s Paradox‖
―The Heckscher-Ohlin-Vanek (HOV) model of factor
service trade is a mainstay of international economics,
Empirically,though,it is a flop…‖ (Davis et al,AER 1997)
―Starting with the classic "paradox" of Wassily W,
Leontief (1953) … the Heckscher-Ohlin (HO) model has
consistently performed poorly in empirical tests,This led
Trefler (1993) to aver that "its predictions are always
rejected empirically.―
In spite of these empirical failures,the Heckscher-Ohlin
model remains ubiquitous in theory,empirics,and policy
analysis,In part,this reflects an a priori belief that the
model embodies fundamental general equilibrium links
between primary factors and production structure that
we believe will be part of any fully articulated and
empirically relevant theory…‖ (421)
Direction of Trade,―Leontief’s Paradox‖
Davis et al,test theory in ―regions that exhibit factor
price equalization (FPE)‖
– Find that ―the theory may do quite well as a simple
description of the data.‖
Choi & Krishna 2004 ―The Factor Content of Bilateral
Trade,An Empirical Test‖ Journal of Political Economy
– Nearly all the tests of the factor content predictions
of the model … have assumed full factor price
equalization (FPE) across countries and identical
homothetic preferences across countries‖
– Their paper ―relies neither on FPE nor on any
restrictions on preferences‖
since ―even casual evidence suggests that full FPE does
not hold … and that preferences are nonhomothetic and
vary substantially with income level…‖
―Factor Price Equalization‖
FPE,prediction that trade would equalise wages & profits
worldwide…
– Clearly false,―even casual evidence suggests that full
FPE does not hold‖ (Choi & Krishna)
But if FPE dropped & HOS ―tested‖…
– Results could simply mean ―countries where labour is
cheap export labour intensive goods…‖ etc.
Trade driven by absolute advantage rather than
comparative
Essential aspect of comparative advantage is
realignment of internal prices & incomes to global prices
& incomes
Trade surpluses
Theory says trade surplus futile because
– With fixed exchange rates causes increase in money
supply
drives up prices
Domestic inflation makes commodities more expensive on
world market
Restores equilibrium
– With floating exchange rate
Causes currency appreciation
Restores equilibrium
What is the empirical record?
– According to Samuelson,it’s conclusive:
Trade surpluses
,while economic protection may raise employment,it
does not constitute an effective program to pursue high
employment,efficiency,and stable prices….
This lesson was amply demonstrated in the 1990s,From
1991 to 1999,the United States created 16 million net
new jobs while maintaining open markets and low tariffs;
its trade deficit increased sharply during this period,By
contrast … Japan had rising unemployment with a growing
trade surplus.‖ (Samuelson,316)
Really? Here’s the data (? WTO)
– http://stat.wto.org
current (nominal) prices
Trade surpluses
US trade deficit began 1968
– Accelerated in 1990s
Japan surplus began 1981
– Constant across 1990s
– Falling in real terms:
Ba l a n c e o f T ra d e
-8 0 0
-7 0 0
-6 0 0
-5 0 0
-4 0 0
-3 0 0
-2 0 0
-1 0 0
0
100
200
1945 1955 1965 1975 1985 1995 2005
Ye a rs
U
S
$
B
i
l
l
i
o
n
J a p a n
U SA
Japan’s stagnation,1989
―Bubble Economy‖ collapse
US boom,Internet Bubble
Trade performances irrelevant
Free trade and development?
Development,Trade,And The WTO
– ―Today,trade policy is at the forefront of the
development agenda,and it is a critical element of any
strategy to fight poverty,This renewed interest in
trade liberalization does not come from dogma but
instead is based on a careful assessment of
development experience over the last 50 years.‖
Hoekman,Mattoo,and English,(Eds.),(xi)
– ―Trade liberalization may have adverse consequences
for some—including some poor people—that should be
avoided or ameliorated to the greatest extent
possible,My fundamental belief,however,is that
trade liberalization aids growth,which,in turn,aids
poverty alleviation.‖ Alan Winters,―Trade Policies for
Poverty Alleviation‖ (28)
Free trade and development?
Economists & formal bodies equally confident:
– ―IMF (1997,84),―Policies toward foreign trade are
among the more important factors promoting economic
growth and convergence in developing countries."‖
– ―OECD (1998,36) states,―More open and outward-
oriented economies consistently outperform countries
with restrictive trade and [foreign] investment
regimes.‖‖ (1)
Rodriguez & Rodrik (2000):
– ―We find little evidence that open trade policies—in
the sense of lower tariff and non-tariff barriers to
trade—are significantly associated with economic
growth.‖ (Abstract)
Free trade and development?
Correlation between trade barriers & growth:
―the slope of
the
relationship is
only slightly
negative and
nowhere near
statistical
significance‖
(2)
Free trade and development?
Recent studies use more complicated indicators of ―openness
to trade‖ imply stronger relationship; but
– ―In many cases,the indicators of "openness" used by
researchers are problematic as measures of trade barriers
or are highly correlated with other sources of poor
economic performance.
– In other cases,the empirical strategies used to ascertain
the link between trade policy and growth have serious
shortcomings,the removal of which results in significantly
weaker findings.‖ (4)
– ―… the nature of the relationship between trade policy and
economic growth remains very much an open question,The
issue is far from having been settled on empirical grounds,
We are in fact skeptical that there is a general,
unambiguous relationship between trade openness and
growth…‖ (6)
Free trade and development?
HOS/Ricardian comparative advantage static
– ―Optimal tariff‖ is zero
R&R present ―dynamic‖ model
– Output=Agriculture + Manufacturing
– Agriculture productivity constant
– Manufacturing productivity
Rises over time
Reflects ―learning by doing‖
– The higher output gets,the more learning occurs
– With otherwise neoclassical assumptions
Wage=marginal product
Equilibrium across both sectors
– Small tariff increases manufacturing sector compared
to agriculture
Free trade and development?
Causes greater growth of manufacturing productivity
– But also devotes some of today’s inputs against
relative productivity today
– ―Hence the tariff exerts two contradictory effects on
growth,By pulling resources into the manufacturing
sector,it enlarges the scope for dynamic scale
benefits,thereby increasing growth,But it also
imposes a static efficiency loss,the cost of which
rises over time as the manufacturing sector becomes
larger.‖ (12)
Working from neoclassical assumptions and ―stylised
fact‖ that growth in manufacturing productivity exceeds
growth in agricultural
– Model suggests optimal tariff > 0 initially and then
should be cut as development occurs
– Thus even neoclassical theory shows…
Free trade and development?
―there is no determinate theoretical link between trade
protection and growth once real-world phenomena such as
learning,technological change,and market imperfections
(here captured by a learning-by-doing externality) are
taken into account.‖ (13)
R&R critique recent papers (e.g,Dollar 1992)
– Many technical aspects to critique
– Main practical one,―Law of one price‖ & ―Purchasing-
power parity‖
Dollar assumes trade barriers only source of nominal
price differences for same good in different countries
– ―Law of one price‖ & ―Purchasing-power parity‖
But this ―Law‖ doesn’t hold empirically:
Free trade and development?
―Rogoff (1996,648) writes of the "startling empirical
failure of the law of one price." … "commodities where
the deviations from the law of one price damp out very
quickly are the exception rather than the rule" (Rogoff
1996,650),
Rogoff (1996,647) concludes … that the speed of
convergence to purchasing-power parity (PPP) is
extremely slow,of the order of roughly 15 percent per
year.
– At this speed of convergence,averages constructed
over a time horizon of 10 years (the horizon used in
Dollar's paper) would exhibit substantial divergence
from PPP in the presence of nominal shocks.‖ (18)
Free trade and development?
Result,Dollar’s index of trade barriers highly distorted:
– ―The ten least distorted countries by this measure
include not only Hong Kong,Thailand,Malta,but also
Sri Lanka,Bangladesh,Mexico,South Africa,Nepal,
Pakistan and Syria!
– Burma's rating (90) equals that of the United States.
– Taiwan (116) is judged more distorted than Argentina
(113).‖ (20)
Similar problems in other influential ―trade promotes
development‖ paper Sachs and Warner (1995)
– Proxies for trade protection closely related to other
issues that may be more important than trade policy:
Free trade and development?
―Indeed,of the 48 economies ranked as closed according
to the BMP criteria,40 had one or more of the following
characteristics:
– average inflation over 1975-1990 higher than 10
percent,
– debt to GNP ratio in 1985 greater than 125 percent,
– a terms-of-trade decline of more than 20 percent,
– an institutional quality index less than 5 (on a scale of
1 to 10),or
– involvement in a war.
In general,strong correlation results for trade openness
& growth ―arise either from obvious mis-specification or
from the use of measures of openness that are proxies
for other policy or institutional variables that have an
independent detrimental effect on growth.‖ (59)
Free trade and development?
―The tendency to greatly overstate the systematic
evidence in favor of trade openness has had a substantial
influence on policy around the world.
Our concern is that the priority afforded to trade policy
has generated expectations that are unlikely to be met,
and it may have crowded out other institutional reforms
with potentially greater payoffs…
The effects of trade liberalization may be on balance
beneficial … the evidence provides no strong reason to
dispute this.
What we dispute is the view,increasingly common,that
integration into the world economy is such a potent force
for economic growth that it can effectively substitute
for a development strategy.‖ (62-63)
Free trade and development?
R&R make one interesting positive observation:
– ―Recent research … has already shed new light on the
relationship between trade and firm performance…
– these papers … find little evidence that firms derive
technological or other benefits from exporting per se;
– the more common pattern is that efficient producers
tend to self-select into export markets.
– In other words,causality seems to go from
productivity to exports,not vice versa…” (62)
i.e.,successful innovators end up exporting
Implies Schumpeterian approach to trade:
―Schumpeterian‖ Trade Theory…
Schumpeterian conjecture
– Trade mainly in innovated products
85% of world trade in manufactures,only 15% is
agriculture/raw materials
Japan’s MITI calculates products invented before 1950
constituted < 20% of sales in 1990
– Exports non-domestic avenue for entrepreneurial
products
Not constrained by local demand/finance
– Surplus means rest of world funds part of domestic
entrepreneurial activity
Potential for more growth
Could be maintained indefinitely so long as maintain
entrepreneurial edge
Trade and growth in general?
Overall message
– Conventional (neoclassical) theory argues getting
prices ―right‖ is the ―one-size-fits-all‖ economic policy
– Careful analysis of the data doesn’t support this
conjecture,many other factors appear to matter:
―There are,in fact,reasons to be skeptical about the
existence of a general,unambiguous relationship
between trade openness and growth,The relationship is
likely to be a contingent one,dependent on a host of
country and external characteristics,The fact that
practically all of today’s advanced countries embarked on
their growth behind tariff barriers and reduced
protection only subsequently surely offers a clue of
sorts.‖ (Rodrik 2002,―Trade Policy Reform as
Institutional Reform‖ Development,Trade,And The
WTO,A Handbook,p,9)
Trade and growth in general?
,One can cite other instances of heterodox trade reforms
that proved successful because they suited existing political
and institutional realities.
Korea’s outward orientation during the 1960s … was achieved
not through import liberalization (of which there was little),
but through export subsidization (of which there was a lot).
– … now prohibited under existing WTO rules on subsidies.
… China’s two-track reform strategy … which maintained
nonmarket institutional forms while aligning incentives
correctly at the margin,has been wildly successful.
These are cases in which imaginative experimentation with
institutional reform has had,in all likelihood,greater payoffs
than the wholesale transplantation of institutions from
advanced industrial countries would have had.‖ (Rodrik 2002,
8)
Whatever happened to…?
Trade theory assumptions seriously at odds with real
world
– Theory,Factors of production ―immobile between
countries,perfectly mobile within‖
Reality,capital (both financial & physical) highly mobile
Enormous international financial capital flows
Large percentage of ―Exports‖ & ―Imports‖ actually
transfers of components between branches of one firm
across national borders,―intrafirm trade‖
– ―In 1994,… intrafirm trade … accounted for more
than one third of U.S,exports of goods and for more
than two fifths of U.S,imports of goods.‖ (Zeile
1997,"U.S,Intrafirm Trade in Goods",Survey Of
Current Business,Vol 75,52–61)
Whatever happened to…?
Intrafirm trade breaches income & welfare aspects of theory
– Comparative advantage
income from trade accrues to factors in country
Relatively abundant factor benefits (workers in 3rd world)
– Intrafirm transfers
Capital income sometimes partly captured locally (joint
ventures,―asset transfer rules‖ [common in China]); but
Often profits remitted to ―home‖ (1st world) country
from ―host‖ (3rd world) country
– Transfer of production done to take advantage of low
wages,different pollution rules,etc.
– May cause rise in wages but depends on
Unemployment levels
Institutional factors (export processing zone
labour laws,unions,etc.)
Whatever happened to…?
– Theory,Trade balanced
Value of imports=value of exports
Exchange rates adjust to maintain equilibrium
Reality,Most countries have sustained trade pattern for
decades—surplus (Japan,Germany…); deficit (USA,
Australia)
Exchange rates haven’t adjusted to achieve trade
equilibrium
– 99% of world currency trade speculative,not to
support exports/imports
Capital (finance) flows to counterbalance trade
imbalances substantial
– Often speculative capital & major cause of currency
valuations (including,e.g.,500% devaluation of
Indonesian rupiah in 1 week in late 1990s)
Trade or innovation?
Conjecture,policies that promote innovation may be more
important than policies that promote ―level playing field‖
Next week,Porter’s management-oriented theory of
competitive advantage
Lecture Twelve:
Standard theories of
international competition
Theory & Reality…
An undisputed truth?
Belief in superiority of free trade near universal amongst
economists
Basic proposition put by Samuelson & Nordhaus:
– ―Simply put,trade promotes specialization,and
specialization increases productivity.‖ (297)
Argument essentially unchanged since Ricardo in 1817:
– Trade lets countries specialise in producing goods in
which they have a comparative advantage:
Not absolute productivity relative to other country,but
Comparative productivity with respect to own industries
Free Trade and Specialisation
Ricardo’s ―Comparative Advantage‖
– Took case Mercantilists argued would mean
rival (Portugal) would ―defeat‖ England in open
trade
Portugal assumed better than England at
producing everything
Argued that England would still benefit from
free trade
– The Model:
Free Trade and Specialisation
Two countries producing 2 commodities
Assume Portugal
– Absolutely more efficient at producing both
wine and cloth
– Relatively more efficient at producing wine
than cloth
More of both wine and cloth produced if
– England specialises in cloth
– Portugal specialises in wine
Countries trade surpluses and increase
consumption of both goods in both countries
Comparative Advantage
Portugal (per 1000 men)
– 90 men to produce x units of cloth
– 80 men to produce y units of wine
– can produce
11.1 units of cloth; or
12.5 units of wine; or
any ―straight line‖ combination of the two
England (per 1000 men)
– 100 men to produce x units of cloth
– 120 men to produce y units of wine
– can produce 10 units cloth,8.5 units of wine,or
any linear combination:
Comparative Advantage
So with no trade:
– Portugal Max,11.1 cloth,or 12.5 wine
– England Max 10 cloth,or 8 1/3 wine
Trade
– Portugal 12.5 wine,England 10 cloth
– Exchange surpluses,total output greater
Putting Ricardo’s arguments in a diagram…
Comparative Advantage
W
ine
Cloth
Wine output
without trade
Cloth output without trade
Cloth output with trade
Wine output
with trade
Trade,England produces only Cloth,
Portugal only Wine; output higher
Comparative Advantage
―Under a system of perfectly free commerce,each
country naturally devotes its capital and labour to such
employments as are most beneficial to each,This pursuit
of individual advantage is admirably connected with the
universal good of the whole,By stimulating industry,by
regarding ingenuity,and by using most efficaciously the
peculiar powers bestowed by nature,it distributes labour
most effectively and most economically.‖ (Ricardo 1817)
Clever logical argument aided repeal of Corn Laws
Identical to modern economic belief
– (Ricardo’s model is economics’ ―one big trick‖)
Show increase in output by reallocating static resources
But behind Ricardo’s rhetoric,a Realpolitik…
Ricardo’s Realpolitik
,It has been my endeavour to shew throughout this work,
that the rate of profits can never be increased but by a
fall in wages,and that there can be no permanent fall of
wages but in consequence of a fall of the necessaries on
which wages are expended,If,therefore,by the extension
of foreign trade,or by improvements in machinery,the
food and necessaries of the labourer can be brought to
market at a reduced price,profits will rise.‖ (Ricardo 1817)
Ricardo’s real interest not efficiency,but
– shift income from landlords to capitalists (workers
irrelevant to Ricardo)
– Real objective to increase rate of investment
Modern Comparative Advantage
If price of wheat falls
– Rents fall
– Money wages fall (cheaper wheat) while real wages
remain constant
– Increased profits
– Greater accumulation
– Objective,promote growth by redistributing income
Neoclassical Heckschler-Ohlin-Samuelson trade model
– Exclusively static
– Therefore ignores income distribution & hence growth
issue
– Basic theory by Heckscher,Ohlin,Samuelson,Vanek
– Best shown using ―Edgeworth Box‖ analysis:
Modern Comparative Advantage
PCs (―capital intensive‖)
Sh
oe
s (
―la
bo
r in
te
ns
ive
‖)
Price ratio
,Production
possibility
curve‖
,Social
indifference
curves‖
production
Consumption
outside PPC
consumption
PCs (―capital intensive‖)
Sh
oe
s (
―la
bo
r in
te
ns
ive
‖)
Modern Comparative Advantage
Fervently believed in by most economists:
– ―The principle of comparative advantage holds that
each country will benefit if it specializes in the
production and export of those goods that it can
produce at relatively low cost,Conversely,each
country will benefit if it imports those goods which it
produces at relatively high cost,This simple principle
provides the unshakable basis for international trade.‖
(Samuelson 300)
– ―Notwithstanding its limitations,the theory of
comparative advantage is one of the deepest truths in
all of economics,Nations that disregard comparative
advantage pay a heavy price in terms of their living
standards and economic growth.‖ (308)
Modern Comparative Advantage
But model makes some extreme assumptions
– Full employment of all factors of production
Otherwise countries would not be on ―Production
Possibility Frontier‖
– Costless mobility of factors of production between
sectors
Labour and capital can be moved from computer
production to shoe production without loss of
productivity
– Immobility of factors between countries
Otherwise gains in one country would accrue to factor
owners in another country
– Identical technology used in production everywhere
Initially,even Samuelson admitted qualms about them:
Modern Comparative Advantage
―The Ohlin analysis explains much; but there is much that it fails to
explain; and if adhered to inflexibly,there is much that it can
obscure,Its two central tenets are open to grave doubt:
Is it reasonable and useful to set up the hypothesis that production
functions are the same the world over? Is it possible to find
reasonably homogeneous and commensurable factors of production in
diverse parts of the world,so that relative proportions can be
defined and compared?
Certainly no strong affirmative answers to these two questions can
be given—as Ohlin himself has pointed out in a number of places,The
laws of nature may be the same ―everywhere,‖ but the laws of nature
and the economically relevant production function relating maximum
output obtainable from specified concrete inputs are two quite
different things…‖ (Samuelson 1948 ―International Trade And The
Equalisation Of Factor Prices‖,Economic Journal Vol,63)
So maybe the ―unshakable basis‖ isn’t all that sound…
Let’s consider the data…
Modern Comparative Advantage
Model makes several empirical predictions:
– Direction of trade determined by relative factor
abundance
Country with relative abundance of capital should export
capital intensive goods
Country with relative abundance of labour should export
labour intensive goods
– Incomes and trade
Trade should cause ―factor price equalization‖,wages
and return on capital should tend to equality throughout
world under freer trade
– Trade surpluses should be counterproductive
Trade surplus should only lead to inflation since
economies in full employment
– Free Trade best route for development
Exploits country’s comparative advantage
Direction of Trade,―Leontief’s Paradox‖
Wassily Leontief (father of input-output analysis)
analysed US trade flows in 1953
– Found that US exports were labour intensive &
imports capital intensive
Exports capital component $14K per man-year
Imports capital component $18K per man-year
Reverse of Heckscher-Ohlin-Samuelson prediction!
– Composite ―export‖ & ―import‖ commodities defined
– Composite ―labour‖ and ―capital‖ factors
– Later generalisations (more disaggregated
commodities & factors) generally reached same result:
Pattern of trade opposite to predictions of HOS theory
– Some recent results find theory valid but only if
another result of theory dropped,factor price
equalization‖…
Direction of Trade,―Leontief’s Paradox‖
―The Heckscher-Ohlin-Vanek (HOV) model of factor
service trade is a mainstay of international economics,
Empirically,though,it is a flop…‖ (Davis et al,AER 1997)
―Starting with the classic "paradox" of Wassily W,
Leontief (1953) … the Heckscher-Ohlin (HO) model has
consistently performed poorly in empirical tests,This led
Trefler (1993) to aver that "its predictions are always
rejected empirically.―
In spite of these empirical failures,the Heckscher-Ohlin
model remains ubiquitous in theory,empirics,and policy
analysis,In part,this reflects an a priori belief that the
model embodies fundamental general equilibrium links
between primary factors and production structure that
we believe will be part of any fully articulated and
empirically relevant theory…‖ (421)
Direction of Trade,―Leontief’s Paradox‖
Davis et al,test theory in ―regions that exhibit factor
price equalization (FPE)‖
– Find that ―the theory may do quite well as a simple
description of the data.‖
Choi & Krishna 2004 ―The Factor Content of Bilateral
Trade,An Empirical Test‖ Journal of Political Economy
– Nearly all the tests of the factor content predictions
of the model … have assumed full factor price
equalization (FPE) across countries and identical
homothetic preferences across countries‖
– Their paper ―relies neither on FPE nor on any
restrictions on preferences‖
since ―even casual evidence suggests that full FPE does
not hold … and that preferences are nonhomothetic and
vary substantially with income level…‖
―Factor Price Equalization‖
FPE,prediction that trade would equalise wages & profits
worldwide…
– Clearly false,―even casual evidence suggests that full
FPE does not hold‖ (Choi & Krishna)
But if FPE dropped & HOS ―tested‖…
– Results could simply mean ―countries where labour is
cheap export labour intensive goods…‖ etc.
Trade driven by absolute advantage rather than
comparative
Essential aspect of comparative advantage is
realignment of internal prices & incomes to global prices
& incomes
Trade surpluses
Theory says trade surplus futile because
– With fixed exchange rates causes increase in money
supply
drives up prices
Domestic inflation makes commodities more expensive on
world market
Restores equilibrium
– With floating exchange rate
Causes currency appreciation
Restores equilibrium
What is the empirical record?
– According to Samuelson,it’s conclusive:
Trade surpluses
,while economic protection may raise employment,it
does not constitute an effective program to pursue high
employment,efficiency,and stable prices….
This lesson was amply demonstrated in the 1990s,From
1991 to 1999,the United States created 16 million net
new jobs while maintaining open markets and low tariffs;
its trade deficit increased sharply during this period,By
contrast … Japan had rising unemployment with a growing
trade surplus.‖ (Samuelson,316)
Really? Here’s the data (? WTO)
– http://stat.wto.org
current (nominal) prices
Trade surpluses
US trade deficit began 1968
– Accelerated in 1990s
Japan surplus began 1981
– Constant across 1990s
– Falling in real terms:
Ba l a n c e o f T ra d e
-8 0 0
-7 0 0
-6 0 0
-5 0 0
-4 0 0
-3 0 0
-2 0 0
-1 0 0
0
100
200
1945 1955 1965 1975 1985 1995 2005
Ye a rs
U
S
$
B
i
l
l
i
o
n
J a p a n
U SA
Japan’s stagnation,1989
―Bubble Economy‖ collapse
US boom,Internet Bubble
Trade performances irrelevant
Free trade and development?
Development,Trade,And The WTO
– ―Today,trade policy is at the forefront of the
development agenda,and it is a critical element of any
strategy to fight poverty,This renewed interest in
trade liberalization does not come from dogma but
instead is based on a careful assessment of
development experience over the last 50 years.‖
Hoekman,Mattoo,and English,(Eds.),(xi)
– ―Trade liberalization may have adverse consequences
for some—including some poor people—that should be
avoided or ameliorated to the greatest extent
possible,My fundamental belief,however,is that
trade liberalization aids growth,which,in turn,aids
poverty alleviation.‖ Alan Winters,―Trade Policies for
Poverty Alleviation‖ (28)
Free trade and development?
Economists & formal bodies equally confident:
– ―IMF (1997,84),―Policies toward foreign trade are
among the more important factors promoting economic
growth and convergence in developing countries."‖
– ―OECD (1998,36) states,―More open and outward-
oriented economies consistently outperform countries
with restrictive trade and [foreign] investment
regimes.‖‖ (1)
Rodriguez & Rodrik (2000):
– ―We find little evidence that open trade policies—in
the sense of lower tariff and non-tariff barriers to
trade—are significantly associated with economic
growth.‖ (Abstract)
Free trade and development?
Correlation between trade barriers & growth:
―the slope of
the
relationship is
only slightly
negative and
nowhere near
statistical
significance‖
(2)
Free trade and development?
Recent studies use more complicated indicators of ―openness
to trade‖ imply stronger relationship; but
– ―In many cases,the indicators of "openness" used by
researchers are problematic as measures of trade barriers
or are highly correlated with other sources of poor
economic performance.
– In other cases,the empirical strategies used to ascertain
the link between trade policy and growth have serious
shortcomings,the removal of which results in significantly
weaker findings.‖ (4)
– ―… the nature of the relationship between trade policy and
economic growth remains very much an open question,The
issue is far from having been settled on empirical grounds,
We are in fact skeptical that there is a general,
unambiguous relationship between trade openness and
growth…‖ (6)
Free trade and development?
HOS/Ricardian comparative advantage static
– ―Optimal tariff‖ is zero
R&R present ―dynamic‖ model
– Output=Agriculture + Manufacturing
– Agriculture productivity constant
– Manufacturing productivity
Rises over time
Reflects ―learning by doing‖
– The higher output gets,the more learning occurs
– With otherwise neoclassical assumptions
Wage=marginal product
Equilibrium across both sectors
– Small tariff increases manufacturing sector compared
to agriculture
Free trade and development?
Causes greater growth of manufacturing productivity
– But also devotes some of today’s inputs against
relative productivity today
– ―Hence the tariff exerts two contradictory effects on
growth,By pulling resources into the manufacturing
sector,it enlarges the scope for dynamic scale
benefits,thereby increasing growth,But it also
imposes a static efficiency loss,the cost of which
rises over time as the manufacturing sector becomes
larger.‖ (12)
Working from neoclassical assumptions and ―stylised
fact‖ that growth in manufacturing productivity exceeds
growth in agricultural
– Model suggests optimal tariff > 0 initially and then
should be cut as development occurs
– Thus even neoclassical theory shows…
Free trade and development?
―there is no determinate theoretical link between trade
protection and growth once real-world phenomena such as
learning,technological change,and market imperfections
(here captured by a learning-by-doing externality) are
taken into account.‖ (13)
R&R critique recent papers (e.g,Dollar 1992)
– Many technical aspects to critique
– Main practical one,―Law of one price‖ & ―Purchasing-
power parity‖
Dollar assumes trade barriers only source of nominal
price differences for same good in different countries
– ―Law of one price‖ & ―Purchasing-power parity‖
But this ―Law‖ doesn’t hold empirically:
Free trade and development?
―Rogoff (1996,648) writes of the "startling empirical
failure of the law of one price." … "commodities where
the deviations from the law of one price damp out very
quickly are the exception rather than the rule" (Rogoff
1996,650),
Rogoff (1996,647) concludes … that the speed of
convergence to purchasing-power parity (PPP) is
extremely slow,of the order of roughly 15 percent per
year.
– At this speed of convergence,averages constructed
over a time horizon of 10 years (the horizon used in
Dollar's paper) would exhibit substantial divergence
from PPP in the presence of nominal shocks.‖ (18)
Free trade and development?
Result,Dollar’s index of trade barriers highly distorted:
– ―The ten least distorted countries by this measure
include not only Hong Kong,Thailand,Malta,but also
Sri Lanka,Bangladesh,Mexico,South Africa,Nepal,
Pakistan and Syria!
– Burma's rating (90) equals that of the United States.
– Taiwan (116) is judged more distorted than Argentina
(113).‖ (20)
Similar problems in other influential ―trade promotes
development‖ paper Sachs and Warner (1995)
– Proxies for trade protection closely related to other
issues that may be more important than trade policy:
Free trade and development?
―Indeed,of the 48 economies ranked as closed according
to the BMP criteria,40 had one or more of the following
characteristics:
– average inflation over 1975-1990 higher than 10
percent,
– debt to GNP ratio in 1985 greater than 125 percent,
– a terms-of-trade decline of more than 20 percent,
– an institutional quality index less than 5 (on a scale of
1 to 10),or
– involvement in a war.
In general,strong correlation results for trade openness
& growth ―arise either from obvious mis-specification or
from the use of measures of openness that are proxies
for other policy or institutional variables that have an
independent detrimental effect on growth.‖ (59)
Free trade and development?
―The tendency to greatly overstate the systematic
evidence in favor of trade openness has had a substantial
influence on policy around the world.
Our concern is that the priority afforded to trade policy
has generated expectations that are unlikely to be met,
and it may have crowded out other institutional reforms
with potentially greater payoffs…
The effects of trade liberalization may be on balance
beneficial … the evidence provides no strong reason to
dispute this.
What we dispute is the view,increasingly common,that
integration into the world economy is such a potent force
for economic growth that it can effectively substitute
for a development strategy.‖ (62-63)
Free trade and development?
R&R make one interesting positive observation:
– ―Recent research … has already shed new light on the
relationship between trade and firm performance…
– these papers … find little evidence that firms derive
technological or other benefits from exporting per se;
– the more common pattern is that efficient producers
tend to self-select into export markets.
– In other words,causality seems to go from
productivity to exports,not vice versa…” (62)
i.e.,successful innovators end up exporting
Implies Schumpeterian approach to trade:
―Schumpeterian‖ Trade Theory…
Schumpeterian conjecture
– Trade mainly in innovated products
85% of world trade in manufactures,only 15% is
agriculture/raw materials
Japan’s MITI calculates products invented before 1950
constituted < 20% of sales in 1990
– Exports non-domestic avenue for entrepreneurial
products
Not constrained by local demand/finance
– Surplus means rest of world funds part of domestic
entrepreneurial activity
Potential for more growth
Could be maintained indefinitely so long as maintain
entrepreneurial edge
Trade and growth in general?
Overall message
– Conventional (neoclassical) theory argues getting
prices ―right‖ is the ―one-size-fits-all‖ economic policy
– Careful analysis of the data doesn’t support this
conjecture,many other factors appear to matter:
―There are,in fact,reasons to be skeptical about the
existence of a general,unambiguous relationship
between trade openness and growth,The relationship is
likely to be a contingent one,dependent on a host of
country and external characteristics,The fact that
practically all of today’s advanced countries embarked on
their growth behind tariff barriers and reduced
protection only subsequently surely offers a clue of
sorts.‖ (Rodrik 2002,―Trade Policy Reform as
Institutional Reform‖ Development,Trade,And The
WTO,A Handbook,p,9)
Trade and growth in general?
,One can cite other instances of heterodox trade reforms
that proved successful because they suited existing political
and institutional realities.
Korea’s outward orientation during the 1960s … was achieved
not through import liberalization (of which there was little),
but through export subsidization (of which there was a lot).
– … now prohibited under existing WTO rules on subsidies.
… China’s two-track reform strategy … which maintained
nonmarket institutional forms while aligning incentives
correctly at the margin,has been wildly successful.
These are cases in which imaginative experimentation with
institutional reform has had,in all likelihood,greater payoffs
than the wholesale transplantation of institutions from
advanced industrial countries would have had.‖ (Rodrik 2002,
8)
Whatever happened to…?
Trade theory assumptions seriously at odds with real
world
– Theory,Factors of production ―immobile between
countries,perfectly mobile within‖
Reality,capital (both financial & physical) highly mobile
Enormous international financial capital flows
Large percentage of ―Exports‖ & ―Imports‖ actually
transfers of components between branches of one firm
across national borders,―intrafirm trade‖
– ―In 1994,… intrafirm trade … accounted for more
than one third of U.S,exports of goods and for more
than two fifths of U.S,imports of goods.‖ (Zeile
1997,"U.S,Intrafirm Trade in Goods",Survey Of
Current Business,Vol 75,52–61)
Whatever happened to…?
Intrafirm trade breaches income & welfare aspects of theory
– Comparative advantage
income from trade accrues to factors in country
Relatively abundant factor benefits (workers in 3rd world)
– Intrafirm transfers
Capital income sometimes partly captured locally (joint
ventures,―asset transfer rules‖ [common in China]); but
Often profits remitted to ―home‖ (1st world) country
from ―host‖ (3rd world) country
– Transfer of production done to take advantage of low
wages,different pollution rules,etc.
– May cause rise in wages but depends on
Unemployment levels
Institutional factors (export processing zone
labour laws,unions,etc.)
Whatever happened to…?
– Theory,Trade balanced
Value of imports=value of exports
Exchange rates adjust to maintain equilibrium
Reality,Most countries have sustained trade pattern for
decades—surplus (Japan,Germany…); deficit (USA,
Australia)
Exchange rates haven’t adjusted to achieve trade
equilibrium
– 99% of world currency trade speculative,not to
support exports/imports
Capital (finance) flows to counterbalance trade
imbalances substantial
– Often speculative capital & major cause of currency
valuations (including,e.g.,500% devaluation of
Indonesian rupiah in 1 week in late 1990s)
Trade or innovation?
Conjecture,policies that promote innovation may be more
important than policies that promote ―level playing field‖
Next week,Porter’s management-oriented theory of
competitive advantage
